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Michael McDonald

Michael McDonald

Michael is an assistant professor of finance and a frequent consultant to companies regarding capital structure decisions and investments. He holds a PhD in finance…

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How To Profit From Crashing Oil Markets

As market volatility heats up amid concerns about Chinese economic ineptitude, investors need to consider adding positions that could offset losses if the markets crash further. The current situation is doubly dangerous for oil investors because so far oil prices have been hit hard by the supply glut. But to the extent that China’s economic growth slows, and as a regional power, potentially drags down the economic growth of its neighbors, that would hit the demand side of the equation for oil. The result is that oil could have further downside from here.

To protect themselves in this scenario, investors should consider inverse oil ETFs as a form of crash protection. This sounds simple, but the fact is that many inverse ETFs are lightly traded and can be dangerous since they use leverage. Puts and short selling of oil stocks are a valid investment choice, but those strategies are not for everyone. With that in mind, it’s worth reviewing a few of these ETFs to see how they stack up. Related: Oil Prices Driven Lower By Everything Except Fundamentals

One reasonable alternative for investors who want some protection from oil price declines but don’t want to take on too much leverage is the Powershare Crude Short Oil ETN trading under ticker symbol SZO. The security is not leveraged, so it mostly moves one for one with oil prices, but the asset base is relatively small at about $40 million. As a result, it is appropriate for smaller investors looking for a little bit of protection, but larger investors may find themselves distorting the price if they try and buy too many shares. SZO also carries a very reasonable 0.75 percent expense ratio.

Another choice with a little bit more liquidity is the ProShares Ultrashort Bloomberg Crude Oil ETF trading under ticker SCO. The security has $170 million in Assets Under Management (AUM), but also has considerably average daily trading volume. SCO has seen a tremendous spike over the last few months, and investors should be rightly wary of putting too much weight on the issue. At the same time, as part of a balanced portfolio, SCO can add a component that is inversely correlated to the broader market, providing a profit when everything else is melting down. The value of such an inverse security was obvious on Monday when, as the rest of the market melted down, SCO was up more than 11 percent. SCO carries a 0.95 percent expense ratio. Related: Why Today’s Oil Bust Is Not Like The 1980s

The security is leveraged though, and tracks 2X the inverse performance of the Bloomberg WTI Crude Oil subindex. Leveraged ETFs like this are very risky given that they can quickly move against an investor causing large losses. Given that, investors need to be sure they understand the risk they are taking on and are comfortable with the holding period for the security.

Similarly, if investors are comfortable with leverage then the Velocityshares 3X Inverse Crude Oil ETN trading under DWTI is another option. As the name implies, the shares are leveraged to track three times the inverse performance of the S&P GSCI Crude Oil Index. DWTI has roughly $220 million in AUM and has enough liquidity to allow most investors to hedge their portfolios against crash risks. The ETF surged more than 16 percent as the markets plummeted on Monday, but that protection comes with a relatively steep 1.35 percent expense ratio. Related: The Real Long Term Threat To The Oil & Gas Industry

There are other good inverse oil ETFs out there, but these three are offered by reputable ETF firms and none of the funds look likely to be closed in the near-term, as so many other ETF funds have been. While there are other ways to protect against downside risks, inverse ETFs offer substantial benefits and are well worth consideration by investors in this market.

By Michael McDonald of Oilprice.com

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